The Internal Revenue Service Code (IRC) Section 1031 is utilized by smart investors and business owners who seek to defer federal and state capital gain and depreciation recapture taxes on the sale of real estate and tangible or intangible personal property held in the productive use of a business or for investment. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming do not have a state capital gains tax. The 1031 exchange is effectively an indefinite interest free loan or additional working capital for use towards acquiring replacement property.
Florida ranks second to Alaska in the number of miles of coastline, followed by California, Hawaii, Louisiana and Texas. Vacation rentals and investment property abound along the Florida coastline and are a primary source of 1031 exchanges. I live in Fort Walton Beach and accommodated 36 percent of 2013 exchanges for Florida properties. The typical 1031 exchange in Florida is for a vacation rental, either a single family residential or condominium, with nearly a third reverse or improvement exchanges. Referrals are received from clients, lenders, attorneys, CPAs, title companies, Realtors and other Qualified Intermediaries. The majority of Florida 1031 exchanges are accommodated for individuals, married and trusts, with an average sales price of less than $400,000. The number of aircraft, equipment and gold and silver bullion exchanges follow those exchanges of real property.
1031 Exchange Code
IRC Section 1031 states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” No gain is recognized means that the tax triggered by the sale is deferred and due once the taxpayer cashes out when selling the replacement property. Hold time is one fact of many that supports the taxpayer’s intent to hold for an investment property versus a flip when property is held primarily for profit.
Florida Vacation Rental Property
Revenue Procedure 2008-16 provides a bright line test and safe harbor for taxpayers given the old property is rented out for a minimum of fourteen overnights in each of two years at fair market rent and the replacement property is also rented out for a minimum of fourteen overnights in each of the two years. The safe harbor means the Internal Revenue Service (IRS) will not challenge whether the vacation property qualifies as property held for productive use under IRC § 1031. Taxpayer’s personal use is not to exceed fourteen overnights per year or 10 percent of the number of days during the 12-month period the property is rented at a fair rental. Those personal overnights attributed to time for repairs and annual maintenance are not a part of the fourteen personal overnights. It is wise to be able to prove work was performed with receipts, invoices and time logs. The taxpayer should also secure evidence of fair market rent from a third party property management company to support rent charged should the IRS audit the 1031 exchange.
The safe harbor is not mandatory. Why not utilize the standards to avoid a fact and circumstance test that most vacation rentals would fail? Taxpayers who view holding their rental property “for investment” may be in for a surprise should their intent not qualify within the meaning of Section 1031. Abandoning personal use prior to the sale does not necessarily qualify for the safe harbor but is a first step towards the personal use quota. A second step is to rent to non-family for at least fourteen overnights for each of two consecutive years prior to the 1031 exchange. Another option is to rent to a family member as their personal residence.
To learn more about 1031 exchanges, download “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking on the button below or call our office with your question.
